The whistleblower who exposed Bernie Madoff thinks the insurance industry is riddled with fraud

Real Vision TV

Nov. 2, 2016, 6:49 PM

Independent financial investigator Harry MarkopolosReal Vision TVThe Big Four accounting firms are so bad at catching fraud that they couldn't even catch a cold, with incentives in the industry totally screwed up. That's the view of the of the whistleblower who uncovered the $65 billion Madoff Ponzi scheme and he thinks fraud is endemic in the insurance industry as well.

Harry Markopolos is the former derivatives professional turned independent financial forensic investigator who spent nine years trying to convince the SEC that Madoff needed to be examined, but it was only the onset of the financial crisis and the massive redemptions he faced that forced Madoff to turn himself in.

Since then he has been a vocal critic of the SEC, writing the 2010 book 'No One Would Listen: A True Financial Thriller'. In a special interview with Real Vision TV, Markopolos now has the institutionalized shortcomings of the audit world in his sights and identified the insurance industry as the next big sector for major financial fraud to come to light.

Madoff Showed How Easy it is to Fool the Big Four Auditors

The fact that Madoff feeder funds were getting clean audit opinions from the Big Four accountants, when Bernie was stealing every dime from day one, shows how easy it was for Madoff to fool the accountants, Markopolos said, adding that in the history of accounting it's impossible to name even one multibillion fraud that the Big Four uncovered.

"Now, if I asked you, to name all the big, multibillion-dollar accounting frauds that the Big Four aided and abetted, we could be here all afternoon," he said.

"The incentives are totally screwed up in the accounting industry. There is no way the company should be paying the audit fees. It should be the shareholders. It should be a fee. Every time you buy a share, a certain number of basis points should be allocated to audit fees. Because the audit fees are currently way too low. Management brags about how low they've gotten the audit fees.

Bernard Madoff exiting the Manhattan federal court house in New York Thomson Reuters "So audit has become a commodity. The people doing the audit, 80% to 90% of the contact hours are by someone in their 20s. Well, who is going to catch fraudsters when you're in your 20s? The only way you're going to catch fraudsters is to have thinning hair, gray hair, or no hair. You have to have been around the block and then burned several times before you're able to catch fraudsters."

Accounting Industry Crying Out for Change

Markopolos goes on to say that shareholders should pay a fee every time they buy a share or purchase a bond, which should go directly to fund the audit. Plus, you need auditors with a range of experience in sectors like banking and insurance or manufacturing so they have the ability to spot fraud. "Whatever that industry is, they know every trick in the book. They've studied every fraud in that industry, and they can detect it readily," he said.

He'd like to see less focus on the young 20-somethings, doing the bulk of the work and better training in terms of uncovering fraud, rather than navigating around the subject. "They don't do a lot of substantive testing, because that's expensive. So what they do instead is they do analytical tests. They just run some numbers through algorithms that they have, and they say, well, that's our test. And then they do very little substantive testing.

"For instance, most of the accounting firms, they'll take 75 sample transactions, and that's what they'll audit. And it might be something very stupid the way they do it. It could be the 25 largest transactions of the company for that year, it could be the 25 newest, and 25 something else. Well, many companies will have millions or tens of millions of transactions, and you're auditing 75 and you're saying that statistically relevant? I say bullshit. That's not relevant at all."

Unregulated Insurance Sector a Recipe for Systemic Disaster

As far as Markopolos is concerned, the insurance sector is a very close cousin to Ponzi schemes by companies that are run poorly,

People exit the AIG building in New York's financial district Thomson Reuters "The insurance industry is unregulated everywhere. In the United States, we have 50 state insurance commissions. I think 43 of them are politically appointed by the governor. Seven of those commissioners run for office," he said. "And it's a race to the bottom in regulation. If you have the easiest insurance regulations, you'll take in the most insurance fees, because operating carriers will choose to domicile in your state and put their employees in your state. And you'll take fees in to your state Treasury."

With only 7c from every dollar of insurance fees going towards regulation to fund the Insurance Commission, the whole industry is a profit making machine for the states, which just want to get the most insurance companies domiciled in order to get the most insurance jobs.

"The gatekeepers are supposed to be the Big Four accountants," Markopolos said. "But we just went into how they're not the gatekeepers. The state insurance commission staff, their investigators are even more poorly trained than the Big Four if that's possible. And so they rely on the Big Four on the financial statements that are put together along with the statutory financial statements that are filed in each state, and they basically run through some mathematical formulas and run some ratio tests and say, well, this company seems solvent.

"Then you have another gatekeeper that's also proven ineffective, and that would be the rating agencies. So if you can't get a job on Wall Street, and if you've graduated with a business degree, and no one else will hire you, who's the hiring authority of last resort? It's the rating agencies. It's for the kids that can't get jobs anywhere else.

"And so the gatekeepers are bad. And then you have the state insurance commissioners that are worse. And they're the low bid for talent. They pay the least. And so they catch no frauds."

SIVS and SPIVs in the Caribbean - A Repeat of 2007 in Insurance

The systemic risk builds because all the insurance companies are putting their reinsurance offshore in the Caribbean and Markopolos contends that you're not going to get the reinsurance market properly regulated there. Furthermore, with cross-risk exposures between insurance companies unknown, it's just like the swaps market and you don't know where the reinsurance really is.

The Cayman IslandsFlickr/Michael Hicks"In 2007 heading into the global financial crisis, we saw how that worked out, with all those hidden liabilities that were sitting in the Caribbean in these special investment vehicles, in these special purpose vehicles and the SIVS in the SPIVs," he said. "They ended up coming back onto the bank's balance sheet and sinking them, resulting in a rescue.

"And in the insurance industry, we saw AIG needed a rescue. We saw Hartford struggle, Lincoln Financial. If it hadn't been for the rescue programs run by the US Treasury and the Federal Reserve, we would have had numerous insurance companies go under. Well, the situation is only worse. Basically the insurance industry is where the banking industry was in 2007."

Insurance Fraud Exposed in 2017

How this all comes out in the wash and who is left holding the baby when the music stops, remains to be seen. In addition to the negative interest rate environment, Markopolos said the insurance industry faces many risks that can't be managed, such as an Ebola breakout or major earthquakes. "You find out that your reinsurers had too much earthquake risk that they were reinsuring. But you weren't measuring that before, because you didn't know to measure it. There is no measurement of cross-risk exposures. And so the whole system collapses. It's a daisy chain, sort of like AIG. If you don't rescue AIG, it's a daisy chain of risk, collapse after collapse, and before you know it, your financial system is blown up," he said.

Warner BrosSo it's almost a lottery in terms of what issue comes along to start the chain reaction, but that doesn't necessarily mean it has to be a natural disaster or a pandemic, with the industry ripe for fraud and financial scandal.

"I have some large insurance fraud cases that I'm going to make public in 2017," Markopolos said. "And they're going to be in the tens of billions of dollars each. And I'm hoping that will be the catalyst for reform, hopefully for some congressional hearings and that we see national regulation of insurance and we see them become Basel compliant. Because there's lot of assets and liabilities there-- there's trillions in assets and liabilities there that are unregulated by anyone. And we don't know what the cross-risk exposures are. And so it's a recipe for a systemic disaster."

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